26 Jun 2012

Sample Essay: Recessions in the United States and the Great Moderation

Introduction

Recessions surge the degree of insecurity within a society and several provoke fears and speculations. Questions such as, why are recessions not thwarted by economists and policy regulators before they occur? Are they caused by defaulting financial intuitions? Why can countries not prevent recessions by strictly governing its potential perpetrators? The essence of all these questions is, why does a recession occur, and why can we not foresee and stop it? However, the answers are many. Intense speculations and fears can cause the stock market to crash. A change in a trading partner’s foreign policies can significantly affect a country’s economy and cause inflation. An economical crisis in an acknowledged economic power can cause a recession in many other countries. Recessions can also occur when the government in a country collapses, either due to a coup d’état or due to the sudden death of a prominent leader. Similarly, the natural disasters, terrorist attacks, or wars can also cause recessions. It can be concluded that the fear of recessions stems from the fact that they degrade the lives of the common people due to factors, such as, rising unemployment rates, national debts, and the plunging valuation of a country’s currency. This paper attempts to analyze the nature of recessions by studying three periods of economic recessions in the United States: 1980–1982, 1990–1991, and 2001. As has been mentioned before, covering all the aspects or reasons behind recessions is difficult, and thus, for the purpose of this paper, Ben Bernanke’s analysis of the Great Moderation will be employed. To begin with, the Keynesian policy of economics—that views changes in the collective demands and thus, increases in spending habits as the powerhouse that propels economic growth—is considered.

Keynesian Policies and Recessions

As its name suggests, the Keynesian policy was developed or propounded by British economist John Keynes, whose work, The General Theory of Employment Interest and Money at the turn of the nineteenth century changed the way economic policies were viewed until then (Boyes and Melvin, 2010, p 218). Keynes pointed out that an economy could be in a state of equilibrium with a GDP that is less than its potential, and that in times of a recession, governments should change their economic policies in order to curb the recession (Boyes and Melvin, 2010, p 218). At a time when people believed that the government should not be directly involved in the macroeconomic policies of a country, Keynes showed that an economy cannot simply subsist on private expenditures—especially during a recession (Boyes and Melvin, 2010, p 218; Buchanan, 1977, p. 10). He imparted the knowledge that the governments should start spending more to initiate monetary outputs and incomes (Boyes and Melvin, 2010, p. 218; Buchanan, 1977, p. 10). In other words, he believed that the fear of a recession makes people want to hoard their money without trusting the banks to keep it safe for them, and this only further destabilizes the economy. Thus, to instigate people to spend and invest, the government should make changes in its policies, such as decreasing interest rates.

Research analyst, Laura Summers (2009) echoes these facts in her article on the subject. She states that the Keynesian theory views recessions as being engendered from disorders—such variability in oil prices, wars, or natural disasters—within the economic system, which affects the aggregate demands, especially in terms of investments (2009). Consequently, the situation becomes compounded by the reactions of the investors, the public, and the government. Saving within households, which is generally regarded as an indication of a healthy economy, only further worsens the recessions. Thus, a “negative feed-back loop” is created and the situation develops into a “paradox thrift” (Summers, 2009). With less money circulation, unemployment rates increase as companies have less money to spend due to decreasing consumption levels and investments. In 1977, Buchanan (p. 129) presented his proposal based on the Keynesian policy that for maintaining stability in an economy, the government should present budgets that transparently show the national targets against the expenditures, which should be followed to the tee unless there is a national emergency.

The Recession of 1980–1982

The recession of the early 1980s actually began in the 1970s and affected most of the globe in its onslaught. In the United States, the economic downfall was caused by more than a single factor. Among the many factors that contributed to this recession, the Iranian Revolution that surged up the oil prices is the most well known (Meltzer, 2010). The energy and oil crises in the 1970s accrued to bring in the inflation in 1980–1982 (Meltzer, 2010). This is direct opposition of the less number of shocks in the following period of the Great Moderation, when there were relatively lesser shocks (Bernanke, 2004). It should also be remembered that the United States was involved in an intense cold war with the communist world in this period, and that tensions were compounded by the increasing threat as both sides gained access to nuclear power—another shock. It is thus possible that the greater number of economic shocks caused this recession—in contrast to the lesser economic shocks during the Great Moderation (Bernanke, 2004). This recession thus became a double dip recession, possibly due to the mistakes made in deciding the monetary policies in this period. The W-shaped curve of the GDP in this period as shown in figure 1. represents this fact (The ABC’s of Recessions).

In 1979, the then newly appointed chairman of the Federal Reserve System, Paul Volcker[Editor1] , propounded a strict monetary policy that he believed would significantly aid in reviving the country from the recession (Meltzer, 2010). In between 1980 and 1982, inflation reached a high of 17 percent and a low of 5 percent as the monetary policies were being amended in the middle of the year (Meltzer, 2010). However, the high interest rates and employment rates continued until 1983 and 1985, respectively (Meltzer, 2010). Volcker because believed that inflation at 11 percent was getting out of hand, and its curbing should be the main goal of the government (Meltzer, 2010). The price inflation was indeed out of control as economists struggled to understand the difference between the projected and real inflation and juggled with various economic theories (Meltzer, 2010). The change of the gold standard into the floating form in reserves only aided in adjusting the exchange rate policies, but challenges on the domestic inflation rate front could not be met (Meltzer, 2010). Moreover, the Volker attempts to control the monetary policy during this recession actually instigated another recession. The strict monetary policies, which had been amended based on the Kyenesian theories, were brought in the middle of the financial year, and strategically poised to make their entrance during the elections. The banks had been asked to reduce their reserves a discount rated were brought down to 10 percent in 1980. Thus, there was a considerable increase in monetary aggregates for about five months in 1980, but once the effects of the disinflation began to be felt, the cracks of the recession began appearing again. From all these factors, it would seem that Bernanke’s (2004) observation that a recession can be caused by economists who have defaulted because they were unable to understand the economy well could be true for the 1980s recession.

The Recession of 1990–1991

Bernanke (2004) states that the three reasons for the Great Moderation that followed the 1980–1982 recession are favorable changes in the monetary policies of the country, structural changes in the economy, and good luck. The factors mentioned above show that Bernanke’s (2004) observation that the output volatility and inflation volatility increases in the 1970s and early 1980s corresponded to the poor monetary policies. Only once the macroeconomic volatility was reduced at around 1984, did the Great Moderation begin to spread roots (Bernanke, 2004). Thus, the global recession of the early 1980s ended fairly early in the United States, but it severed the power of the communists by bringing an end to the Soviet regime. The United States thus thrived in a long period of peace in the later part of the 1990s. Good monetary policies, the factor Bernanke (2004) seems to favour the most, were perhaps the most significant contributing factor for the Great Moderation. Nevertheless, the ability of a good economic structure to prosper without any economic shocks cannot be ruled out as reason for the low macroeconomic volatility of the Great Moderation (Bernanke, 2004). Thus, at the beginning of the 1990s, the United States’ economy was at its peak, but by July 1990, the country went into an eight-month long recession, and it emerged from it in March 1991 (Stock and Watson, 2002, p. 159).

The[Editor2] actual commencement of this recession can be traced back to 1987, when stock markets across the world crashed miserably (Browning, 2007). In the United States, this impact was felt relatively low, as with the elections around the corner, the reactions to this recession were almost missed. Browning (2007) states that no one remembers this recession because it did not “seriously hamper economic growth.” Thus, as Bernanke (2004) would state, the lesser number of shocks buffered the economy from a complete downfall. However, while the impact of the recession was not felt at the beginning by mid-1990, as the Gulf War gained momentum and oil prices increased, there were a few months of recession (Browning, 2007).

While the shocks were, however, felt gradually, the consumer buying behavior saved the country from suffering excessively in this period. Bernanke (2004) mentions that after the 1981–1982 fiasco, the methods by which central banks should charge interest rate became an important matter. Economist John B. Taylor developed a model based on the price and wage of the time using the Keynesian models. Bernanke (2004) believes that the employment of this model for deciding nominal interest rates could also be a significant reason behind the Great Moderation. It can also be viewed that the low impact of the 1990–1991 recession (and even the 2001 recession, as has been mentioned ahead) was due to the effectiveness of the Taylor curve model.

Stock and Watson [Editor3] (2002, p. 199–200) believe that while there were strong indications of decline in the volatility of economic activity, the real GDP had significantly decreased in the middle of 1980s. This, they state, was apparent in the difference in the rate of consumption, production of durable goods, residential fixed investment, and in the production of structures across all quarters. Thus, it can be seen that this recession did not actually affect all sectors. They too are in agreement with Bernanke (2004), who was the chairperson of the Federal System of Reserves in this period, that there is no clarity about the reasons behind the Great Moderation. They believe that it could be the improved monetary policy or Federal System changed response to the inflation from the mid-1980s onward that might be some of the reasons. They also agree with Bernanke (2004) on the point that whatever the reasons behind the Great Moderation, it did help in reducing the output volatility, which is known to edge an economy towards a healthier path.

The Recession of 2001

The recession of 2001 has been called a “short” and “shallow” recession like the 1990–1991 recession (Kliesen, 2003, p. 23). Like the 1990–1991 recession discussed above, it was occurred after a period of economic expansion and ended in November 2001, before its actual impact could be felt with full force (Kliesen, 2003, p. 23). Figure 2 shows a U-shaped GPD in the 1990–1991and 2001 recessions, an indication of typical recessions that are preceded by a period of economic expansion followed by a downfall and recovery (The ABC’s of Recessions). In fact, this does give rise to the question if every period of expansion should be carefully regulated because of the recession that can potentially follow in its aftermath (Kliesen, 2003, pp. 23–24). As the National Bureau of Economic Research states that to be called a recession, a economic downturn should last for at least nine months on an average, this “recession” falls short by this benchmark (Kliesen, 2003, p. 23). It is found that this recession was somewhat a shock to the economists (Kliesen, 2003, p. 27). Thus, economic forecasters had had overestimated the ability of the economy in this period (Kliesen, 2003, p. 27). Moreover, it was wrongly estimated that the economical growth after September 2001 was expected to decline (Kliesen, 2003, p. 27). Like the recession of 1990–1991, varied consumer spending resulted in some sectors getting affected by the recession more than the others (Kliesen, 2003, p. 28). An unexpected decline in the net exports due to the appreciation of the USD and a worldwide decline in slowdown in economic activity also contributed to this recession (Kliesen, 2003, p. 27).

Toward the end of his speech Bernanke reinstates his faith in the ability of the good monetary policies to thwart of buffer the impact of a recession by stating that even the favorable shifts in the Taylor curve in the Great Moderation period could have been instigated by good monetary policies. He makes four statements that stand by his opinion on this: (1) The monetary policies could have stabilized inflation, which in turn stabilized the structure of the economy. (2) Although shocks are thought to be exogenous events, many-a-times, these shocks are actually instigated by expansionary monetary policies. (3) A good monetary policy can also safeguard the economy against shocks by being sensitive to the distribution of the shocks. (4) Finally, alterations in the inflation expectations are actually perpetrated by monetary policies and often mistaken to be exogenous shocks, and so, a good monetary policy will negate this effect. In the 2001 as well as in the 1990–1991 recessions, the low impacts on the economy were owing to the same policies that were being followed in the wake of the 1980–1981 recessions, that is, in the Great Moderation period. Thus, the four points stated by Bernanke above could very well be the reason behind these low-impact recessions.

Conclusion

Using Bernanke’s analysis, it can be observed that in the recession of 1980–1982, the economists were probably unable to understand the economy well enough to take appropriate steps to safeguard it. It can also be concluded that the increased inconsistency in the economy, that is, more economic shocks could have furthered the decline of the economy in this period. The exact contrasting factors were found to be the reasons behind the Great Moderation in the following period. The next recession, that is, the one between 1990 and 1991, was a short one and almost neglected by the people of the country. However, economic volatility has been said to be the contributing factor behind this recession. It is also found that Bernanke’s (2004) concepts regarding the Great Moderation—that the improved monetary policies were crucial to the growth in this period—are in coherence with the findings of other researchers. The 2001 recession is comparable to the 1990–1991 one in that it resembles the short duration for which it lasted and the fact that it was followed by an period of economic expansion. It can, however, be concluded that finding the causes behind recessions is extremely difficult, and while improved monetary policies are an potential cause behind an expanding economy and vice versa, this fact cannot be marked on stone. Moreover, it can also be seen from the 1980–1982 recession that Keynesian theories, while relevant even today, should not be adhered to blindly. The Taylor curve, a important model based on the Keynesian theories has been known to be helpful in deciding the nominal interest rates of central banks. It is possible that this model was responsible for buffering the United States from the recessions of 1990–1991 and 2001 as well as for aiding the prosperity of the country’s economy during the Great Moderation—although Bernanke favors monetary policies as the major contributing factor.

References

Browning, E.S. “Exorcising Ghosts of Octobers Past: Despite Housing Slump, Crashes Such as in 1987 Likely to Stay Memories,” (October 19, 2007), The Wall Street Journal. Accessed on April 30, 2012 http://online.wsj.com/article/SB119239926667758592.html

Bernanke, Ben S. Remarks by Governor Ben S. Bernanke At the meetings of the Eastern Economic Association, Washington, DC (February 20, 2004). The Great Moderation Accessed on April 30, 2012 http://www.federalreserve.gov/boarddocs/speeches/2004/20040220/default.htm.

Boyes, William and Melvin, Michael. Economics. Eagan: Cengage Learning, 2010.

Buchanan, James M. Democracy in Deficit: The Political Legacy of Lord Keynes, Online Library of Liberty, 1977.

Kliesen, Kevin L. The 2001 Recession: How Was It Different and What Developments May Have Caused It? The Federal Reserve Bank of St. Louis (September–October, 2003), pp. 23–37.

Meltzer, Allan H. A History of the Federal Reserve—Part VIII: Volcker Imposes Monetary Austerity (1979–1986),  Futurecasts Online Magazine, 12(8) (August 1, 2010). Accessed on April 30, 2012 http://www.futurecasts.com/Meltzer,%20History%20of%20Federal%20Reserve,%20v.%202%20%28VIII%29.htm#Recession%20of%201980-1982.

Summers, Laura. Thoughts on the Current Recession: Keynesian Economics (May 1, 2009), Utah Foundation Research Brief. Accessed on April 30, 2012 http://www.utahfoundation.org/reports/?page_id=437.

Stock, James H. and Watson, Mark W. Has the Business Cycle Changed and Why? Ed. Mark Gertler and Kenneth Rogoff (April 5–6, 2002), NBER Macroeconomics Annual 2002, 17. Accessed on April 30, 2012
http://www.nber.org/chapters/c11075.

The ABC’s Of Recessions (August 15, 2009). Accessed on April 30, 2012 http://www.targoz.com/blog/the-abcs-of-recessions.html.

Appendix

Figure 1. The W-shaped GPD of the 1980–1982 recession shows that this was a double-dip recession

1980–1982 W Recessions

Source: The ABC’s Of Recessions (August 15, 2009). Accessed on April 30, 2012 http://www.targoz.com/blog/the-abcs-of-recessions.html.

Figure 2. The U-shaped GPD of the 1990–1991and 2001 recessions shows that they were typical recessions with a period of economic expansion followed by a downfall and recovery

1990–1991 & 2001 U Recessions

Source: The ABC’s Of Recessions (August 15, 2009). Accessed on April 30, 2012 http://www.targoz.com/blog/the-abcs-of-recessions.html.


[Editor1]YOU CAN DELETE THE COMMENT BOXES BY RIGHT CLICKING AND CHOSING DELETE COMMMENT BOX

Bernanke mentions him as well.

[Editor2]I have followed the pattern of mentioning the major attributes of each of the recessions and comparing them to Bernanke’s observations. So, the 3 basic reasons (2 if you look at the good luck factor as a consequence of the lesser number of shocks) for the Great Moderation have been mentioned for all the recessions. So Bernanke is present everywhere!

[Editor3]This is a study that agrees with Bernanke’s observations.

24 Aug 2009

Sample Essay: Growth and the Inflation

It is no doubt that both of these processes pull each other and business is the fluctuating transition between the two. Combating inflation would be counterproductive as it will bring down the growth. Soaring prices of commodities globally, will only result degrading the monetary value of a country. But this cannot be related with just particular country, as this process is globally, that means growth is taking over inflation. The best example is people now enjoy privileges of hiked incomes and incentives, will only push the prices high. Value of anything states that it could not be of any worth, if everyone possesses it. On contrary, prices are rising due to shortage of services, lack of available raw material and expensive processing charges.

For example: The crude prices are shooting exorbitantly, is the recent global turmoil. Every possible effort is being done to keep the Oil prices under control, but reason is very clear. Costly drilling rigs, shortages of operating tools, unavailability of required service, etc have pushed up the prices. Moreover, persons working there, to explore for oil are facing hardships, risk to lives and staying away from their families, will not only lured by fixed salary, but in addition to that incentives are paid from time to time to achieve the estimated target within time limit. Thus until this stage, when the crude is about to sold in the market, all the expenditure will become burden on consumer. This way the prices kept increasing for public, day by day.

Contrary to this, there was a period of 3 years in 1990’s when oil business was on its low and struggled to mark their presence in market. The reason was, crude prices went down tremendously this led all operators and Oil companies not to take out oil as the rates in which they have to market the Oil is lower than their expenditure, that would have made business losses, result was they avoided exploring oil. The outcome of this is that inflation does not mean bad for growth, but it fluctuates under the effect of demand and supply statistics of the market.

Now-a-days in US, there is spurt in demand for meat, eggs, milk that is basic commodities. It can be straight away be termed as Inflation, but as this is a global phenomena, this is that we all are heading towards growth. For countries, that are incapable to match the pace of rapidly developing nations in terms of economy, will definitely face price rise and will be the sole effect of Inflation. Supply demand mismatch arise due to structural shift in demand that is induced by fast growing sectors.

Recent market scenario is analyzed as a result of inflation, on other side that whether it may or may not be, national governments are taking concrete steps to control price rise by making it subsidized, putting ban on exports and eliminating duties on basic products.

After all there is a strong cooperation between World Bank, IMF and UN Food & Agricultural Organization, even that has failed to make any positive efforts and that threatens the macroeconomic stability. Many big companies in US are outsourcing their manpower, in order to cut cost to gain net profit. It cannot be just of inflation, but a reason of cheap resources and opportunities outside US.

Thus one can say that growth is answer to the current bout of high inflation. Inflation is not neutral and in no case if favors rapid economic growth. Also higher inflation never leads to higher income levels in medium and long runs. Inflation reduces the business investments and also reduces productivity. Control on inflation regularly will pay off sooner or latter, resulting in higher per-capita income and thereby pushing national on economic terms.

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26 Jun 2009

Sample Essay: 1973 Recession

1973, is considered by many analysts as the turning point in the history of the twentieth century. Pre-1973, the world had become accustomed to an abundant supply of inexpensive fossil fuels: coal, petroleum, and natural gas. The developed nations had built their economic edifice on the premise of assured availability of cheap fossil fuel. The availability of these fossil fuels was taken for granted, so much so; that the economic health of most of the developed nations depended entirely upon their steady and continued availability.  For example, the average price of a barrel of oil in 1973, was $2.70 and the average cost of gasoline at the pump about 35¢ a gallon.

An assortment of unrelated but equally important factors combined in 1973, to change this picture dramatically. The most prominent of those factors was a decision made by the Arab members of the Organization of Petroleum Exporting Countries (OPEC) to impose drastic cuts on its export of petroleum to the developed nations of the world due to the American support to Israel during the 1973 Arab-_Israeli War. The decision taken on October 18, 1973, curtailed the direct flow of fossil fuel to the US to almost Zero. The sudden implementation of the oil embargo by the OPEC countries put the US economy under severe strain, and the consequence was a soaring inflation beyond 10% a year, mounting interest rates and unmanageable trade deficit.

It must be borne in mind that the rate of inflation was considerably high, even before the oil embargo was imposed by the OPEC countries. The pattern right through the later half of the 60 and spilling over to the early 70s indicated a reasonable Fed tolerance for rising inflation. Notwithstanding  Fed  propensity to fight inflation, their decision to contract substantially in 1973-74, at a time when the economy was already passing through a critically downward  phase was neither inevitable nor likely. It is pertinent to highlight the fact that the expansionary monetary policy accounts for a major portion of the blame for the inflation during the early 1970s. Tight monetary policy is conventionally thought to be the proximate cause of the fiscal downturn. Thus, monetary policy and the oil crisis precipitated the economic distress in the US thereby leading to the recession of 1973.

CAUSES OF RECESSION

Decreasing GDP. Scrutiny of the financial data from the fourth quarter of 1973 (1973 IV) to 1975 I  indicates that the  real GDP was decreasing steadily. Since the decrease in GDP was only  6.8 percent, it was not an alarming decline; the point of concern was that the rate of unemployment  was increasing substantially. The aspect of concern however was the catastrophic decline of Investment Purchases. Figures from the Bureau of Economic Analysis of the U.S. Department of Commerce for quarterly real Gross Domestic Product (GDP) levels ( in billions of  dollars) are indicated in the table below:

Srl No                         Quarter           GDP

(a)                   1973 III          1236

(b)                   1973 IV          1241

(c)                   1974 I                         1229

(d)                   1974 II            1217

(e)                   1974 III          1210

(f)                    1974 IV          1187

(g)                   1975 I                         1157

(h)                   1975 II            1168

Unemployment.Although the real GDP is a primary factor for determining and defining a recession ,it gets  manifested and  perceived in terms of the unemployment rate for the corresponding period. For the period under consideration, i.e.  1973 IV to 1975 IV ,  the quarterly unemployment figures for the US were as follows:

Srl No                         Quarter           GDP

(a)                   1973 IV          4.9%

(b)                   1974 I                         5.0%

©                     1974 II            5.3%

(d)                   1974 III          5.9%

(e)                   1974 IV          7.2%

(f)                    1975 I             8.5%

(g)                   1975 II                       8.7%

(h)                   1975 III          8.6%

(j)                    1975 IV          8.3%

From the above mentioned details it can be concluded that the rate of unemployment went up drastically  from the five percent level to nearly the nine percent in a span of 18 months. For a given period ,if the number of jobs created is lower than the net increase in the labour force available, it results in a corresponding increase in the unemployment rate. This implies that to have a viable increase in the number of jobs available, the growth of real output has to exceed the increase in the rate of productivity. Reduced output leads to excessive decline in the number of jobs.

Investment purchases. It is identified as the most important variable of concern, as  has been amply demonstrated on various occasions in History . It can be safely stated that the principle cause leading to the  Great Depression of the 1930’s was the catastrophic collapse of investment purchases. Other prior causes existed , like steep rise in real interest rates due to the restrictive monetary policies( a point of concern), but these factors have their effect in investment purchases. Economic analysts and decision makers had observed a similar pattern for the investment conditions in 1975, and in fact, it was the indicator of  a catastrophic collapse in progress.

FISCAL POLICY (Fed Reserve)

Having identified collapsing investment purchases as the principle factor leading to the recession, it was widely perceived in the second quarter of 1975  that a remedial measure was urgently needed, and that introduction of a tax cut was the most effective anti-recession measure. However, this proposal was not acceptable and convincing to everone as a substantial number of economists felt that a tax cut that lead to a government deficit meant increased borrowing by the government financial markets which would effectively push out the private borrowers thereby curtailing their investment purchases. President Gerald Ford planned to seek re-election in November 1976 , and it would not be acceptable for the country to be in a recession  at election time. Hence, he wanted to have the cut in place. At this time ,  The head of the Council of Economic Advisors for Gerald Ford  was Alan Greenspan.

Three major issues identified to be resolved by the Proposed Gerald Ford – Alan Greenspan Tax reduction Plan were  the immediate problem of recession and unemployment, rising  inflation, and the need to identify alternative energy sources in the light of American vulnerability to oil embargoes. However, analysis of the tax -cut   scheme along with the proposed energy tax increase, revealed that the net stimulus to the economy would be negligible since  no net tax cut was involved. Infact, the impact of the balance of the plan would result a decrease in aggregate demand of $2 billion. As it was felt that the package would have no positive impact on the economy, Congress rejected the proposed package and enacted its own tax cut.

THE RECOVERY AND EXPANSION

The following table shows the cash flows for the Federal government for the period along with the investment purchases: – (Billions $)

Quarter           Receipts          Expenditures             Deficit Investment Purchases

1973 III          260                        265              5              206

1973 IV          266                        271               5             213

1974 I                         276                        281               5             196

1974 II            286                        294              8             184

1974 III          299                        307               8             173

1974 IV          293                        319                25          167

1975 I                         284                       337                54              130

1975 II            250                        352               102             124

1975 III          293                       364                  71           148

Source: Economic Reports of the President, 1975, 1980

Although the tax cut came in to effect through changed withholding in the first quarter of 1975,  its impact was observed in the second quarter of 1975. It led to a huge increase in the Federal budget deficit  $25 billion to $54 billion to $102 billion, which in turn dictated a significant  increase in Federal borrowing from the financial markets. Despite this, in the third quarter, there was an increase of 19 % in investment purchases which was financed in part by private borrowing. The increase in Investment continued steadily and went up to $154 billion in the fourth quarter of 1975.

Thus, it was experienced that although the tax cut led to increased government borrowing from theb financial markets, it did not lead to crowding out of the private investment .In fact, private borrowing for private investment was instead  enticed  by the credible prospect of a  recovering economy that would again  become robust. Investment is not solely a function of the real interest rate, and it became clear that investor confidence and expectations of future growth prospects of the economy are more important factors determining levels of investment. The real interest rate may not be the  most important determinant of investment.

The level of real GDP increased for the $1168 billion in 1975II to $1201 billion in 1975III. Real GDP then increased to $1217 billion in 1975IV. The recession was over. The figures are as follows:-

Srl No                         Quarter           GDP

(a)                   1975 I                         1157

(b)                   1975 II            1168

(c)                   1975 III          1201

(d)                   1975 IV          1217

CONCLUSION

The tax cut led to increased government borrowings from the financial markets, but it did not result in crowding out the private investments. Instead, it only encouraged increased participation by private purchases/investments. Thus it can be inferred that the signs of a financial recovery and portends for a healthy growth output are more important factors encouraging the level of investment purchases. Since the tax cut was planned and structured appropriately, it was effective at stimulating the economy. Decline in public investment probably occurred due to the expectations of tightfisted economic policy in order to fight inflation  and sluggish growth output. Although, interest rates increased, the net increase was not adequate to bring about hike in real interest rates. These were important lessons in fiscal policy. And another lesson is to beware of the assumption that because investment and interest rates are closely interlinked, any increase in investment   depends only upon interest rates.

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